International Finance Theory and Policy
by Steven M. Suranovic

Finance 5-1

The National Income and Product Accounts

Many of the key aggregate variables used to describe an economy are presented in a country's National Income and Product Accounts (NIPA). National income represents the total amount of money that factors of production earn during the course of a year. This includes, mainly, payments of wages, rents, profits and interest to workers and owners of capital and property. The national product refers to the value of output produced by an economy during the course of a year. National product, also called national output, represents the market value of all goods and services produced by firms in a country.

Because of the circular flow of money in exchange for goods and services in an economy, the value of aggregate output (the national product) should equal the value of aggregate income (national income). Consider the adjoining circular flow diagram describing a very simple economy. The economy is composed of two distinct groups, households and firms. Firms produce all of the final goods and services in the economy using factors services (labor and capital) supplied by the households. The households, in turn, purchase the goods and services supplied by the firms. Thus goods and services move between the two groups in the counterclockwise direction. Exchanges are facilitated with the use of money for payments. Thus when firms sell goods and services, the households give the money to the firms in exchange. When the households supply labor and capital to firms, the firms give money to the households in exchange. Thus, money flows between the two groups in a clockwise direction.

National product measures the money flow along the top part of the diagram; i.e., the money value of goods and services produced by firms in the economy. National income measures the money flow along the bottom part of the diagram; i.e., the money value of all factor services used in the production process. As long as there are no money leakages from the system national income will equal national product.

The national product is commonly referred to as gross domestic product or GDP. GDP is defined as the value of all final goods and services produced within the borders of a country during some period of time, usually a year. A few things are worth emphasizing about this definition.

First, GDP is measured in terms of the money, or dollar, value at which the items exchange in the market. Second, GDP measures only final goods and services as opposed to intermediate goods. Thus wheat sold by a farmer to a flour mill will not be included as part of GDP since the value of the wheat will be included in the value of the flour that the mill sells to the bakery. The value of the flour will in turn be included in the value of the bread sold to the grocery store. Fianlly the value of the bread will be included in the price charged by the grocery when the product is finally purchased by the consumer. Only the final bread sale should be included in GDP or else the intermediate values would overstate total production in the economy. Finally, GDP must be distinguished from another common measure of national output, gross national product, or GNP.

Briefly, GDP measures all production within the borders of the country regardless of who owns the factors used in the production process. GNP measures all production achieved by domestic factors of production regardless of where that production takes place. For example, if a US resident owns a factory in Malaysia and earns profits on the operation of that factory, then those porfits would be counted production by a US factor owner and thus would be included in GNP. However, since that production took place beyond US borders, it would not be counted as GDP. Alternatively, if a Dutch resident owns a factory in the US, then the fraction of that production which accrues to the Dutch owner would be counted as part of GDP since the production took place in the US. It would not be counted as part of GNP, however, since the production was done by a foreign factor owner.

GDP is probably the most widely reported and closely monitored aggregate statistic. GDP is a measure of the size of an economy. It tells us the total amount of "stuff" the economy produces. Since most of us, as individuals, prefer to have more stuff rather than less, it is straightforward to extend this to the national economy to argue that the higher is GDP, the better off is the nation. For this simple reason, statisticians track the growth rate of GDP. Rapid GDP growth is a sign of growing prosperity and economic strength. Falling GDP indicates a recession, and, if GDP falls significantly, we call it an economic depression.

For a variety of reasons GDP should be used only as a rough indicator of the prosperity or welfare of a nation. Indeed many people contend that GDP is an inadequate measure of national prosperity. Below is a list of some of the reasons why GDP falls short as an indicator of national welfare.

1) GDP only measures the amount of goods and services produced during the year. It does not measure the value of goods and services left over from previous years. For example, used cars, two-year old computers, old furniture or houses, etc., are all useful and provide welfare to individuals for years after they are produced. And yet, the value of these items are only included in GDP in the year in which they are produced. National wealth, on the other hand, measures the value of all goods, services and assets available in an economy at a point in time and perhaps is a better measure of national economic well-being than GDP.

2) GDP, by itself, fails to recognize the size of the population which it must support. If we want to use GDP to provide a rough estimate of the average standard of living among individuals in the economy, then we ought to divide GDP by the population to get per capita GDP. This is often the way in which cross country comparisons are made.

3) GDP gives no account of how the goods and services produced by the economy are distributed among members of the economy. One might prefer a lower GDP with a more equitable distribution to a higher GDP in which a small percentage of the population receives most of the product.

4) Measured GDP growth may overstate the growth of the standard of living since price level increases (inflation) would raise measured GDP. Thus even if the economy produces exactly the same amount of goods and services one year as the year before, if the prices of those goods rise, then GDP will rise as well. For this reason, real GDP is typically used to measure the growth rate of GDP. Real GDP divides nominal (or measured) GDP by the price level, and is designed to eliminate some of the inflationary effects.

5) Sometimes economies with high GDPs may also produce a large amount of negative production externalities. Pollution is one such negative externality. Thus one might prefer to have a lower GDP and less pollution than a higher GDP with more pollution. Also some groups argue that rapid GDP growth may involve severe depletion of natural resources which may be unsustainable in the long-run.

6) GDP often rises in the aftermath of natural disasters. Shortly after the Kobe earthquake in Japan in the 1990s, economists predicted that Japan's GDP would probably rise more rapidly. This is mostly because of the surge of construction activities required to rebuild the damaged buildings. This illustrates why GDP growth may not be indicative of a healthy economy in some circumstances.

International Finance Theory and Policy - Chapter 5-1: Last Updated on 10/27/01